Fordham Urban Law JournalVolume 16, Number 3 1987 Article 4

Disbursement Of Insurance Money CoveringAn Insured’s Legal Expenses As Incurred

Arthur P. Xanthos∗

∗

Copyright c©1987 by the authors. Fordham Urban Law Journal is produced by The BerkeleyElectronic Press (bepress). http://ir.lawnet.fordham.edu/ulj

Disbursement Of Insurance Money CoveringAn Insured’s Legal Expenses As Incurred

Arthur P. Xanthos

Abstract

In the Southern District of New York, Pepsico, Inc. v. Continental Casualty Co. held that theD & O insurance carrier was obligated to pay the insured’s costs as they accrue, subject to reim-bursement should adjudication show that there were no grounds for coverage. This Note proposesthat the Pepsico rule favoring the insured is the more judicious view regarding interim payments.This Note discusses the differing interpretations of D & O policy defense cost clauses, and thenanalyzes the Pepsico rule from the standpoints of reasonable expectations, contract interpretationand unconscionability. After comparing D & O insurance with standard liability insurance, thisNote recommends adoption of the Pepsico rule in other jurisdictions.

KEYWORDS: liability, insurance, director, officer, fiduciary

DISBURSEMENT OF INSURANCE MONEYCOVERING AN INSURED'S LEGAL EXPENSESAS INCURRED

I. Introduction

Directors' and officers' liability insurance (D & 0 insurance)provides coverage for costs incurred by a director or officer indefending a third-party claim.' Because directors and officers2 standin a fiduciary relationship' to their corporation and its shareholders, 4

they may be held personally liable if they fail to perform their dutieswith due care and financial damage to the corporation results.5

Moreover, litigation costs can be enormous 6 and lawsuits can last

1. See Goldstein & Gordon, Directors' and Officers' Liability Insurance, FORTHE DEF. 2 (Aug. 1987) [hereinafter Goldstein & Gordon]; Johnston, CorporateIndemnification and Liability Insurance for Directors and Officers, 33 Bus. LAW.1993, 2013, 2015-16 (1978) [hereinafter Johnston]; Oettle & Howard, D & 0Insurance: Judicially Transforming a "Duty to Pay" Policy into a "Duty to Defend"Policy, 22 TORT AND INs. L.J. 337, 337 (1987) [hereinafter Oettle & Howard];Comment, Practical Aspects of Directors' and Officers' Liability Insurance-Allocating and Advancing Legal Fees and the Duty to Defend, 32 UCLA L. REV.690, 690 (1985) [hereinafter Practical Aspects].

2. For the purposes of this Note, the term director(s) is used to mean director(s)or officer(s) or both.

3. "Fiduciary relationship" has been defined in the following manner:One is said to act in a "fiduciary capacity" . . . when the business whichhe transacts, or the money or property which he handles, is not his ownor for his own benefit, but for the benefit of another person, as to whomhe stands in a relation implying and necessitating great confidence andtrust on the one part and a high degree of good faith on the other part.

BLACK's LAW DICTIONARY 564 (5th ed. 1979).4. "The relation of an officer of a corporation to it is fiduciary, and he must

at all times act in good faith and unselfishly toward the corporation." Jacobsonv. Brooklyn Lumber Co., 184 N.Y. 152, 162, 76 N.E. 1075, 1078 (1906); see alsoAlpert v. 28 Williams St. Corp., 63 N.Y.2d 557, 568, 473 N.E.2d 19, 25, 483N.Y.S.2d 667, 673 (1984); Fe Bland v. Two Trees Mgmt. Co., 125 Misc. 2d 111,116, 479 N.Y.S.2d 123, 127, aff'd, 109 A.D.2d 1110, 487 N.Y.S.2d 159 (1st Dep't1985).

5. See Goldstein & Gordon, supra note 1, at 2.6. See id.; Johnston, supra note 1, at 1993; Practical Aspects, supra note 1,

at 709.

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for indeterminate periods of time. 7 An institution will, therefore,often purchase D & 0 insurance' to alleviate the financial risk ofcrippling defense costs to its directors9 in instances where they maynot be indemnified by the institution.10

D & 0 insurance is a relatively new form of liability coverage.1'Although D & 0 policies were first marketed in the 1950's, theyreceived scant attention from commentators until the mid-1960's. 2

Lloyd's of London, the well known British insurance giant, 3 dom-inated the D & 0 insurance market until the late 1960's.14 Today,several American companies in addition to Lloyd's offer D & 0insurance coverage, 5 although the number of insurers willing to offerit has decreased in recent years.' 6

Unlike most other liability insurance, D & 0 insurance does notrequire the insurer to assume the insured's defense; 7 rather, it imposesupon the insurer a duty to pay the insured's defense costs.'" Although

7. See Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1468 (W.D. Pa.1986), aff'd, 836 F.2d 789 (3d Cir. 1987); Practical Aspects, supra note 1, at 694.

8. A corporation may itself indemnify its directors for some forms of liability,but state statutes strictly regulate areas of allowable coverage. See N.Y. Bus. CORP.LAW § 726 (McKinney & West Supp. 1987). The corporation may, therefore, optto purchase insurance from outside sources. Then when a director seeks to financehis legal defense, he either approaches his corporation (for "advances") or itsinsurance carrier (for "interim payments"). See Practical Aspects, supra note 1,at 709.

9. See Little, 649 F. Supp. at 1461.10. See Johnston, supra note 1, at 2004. New York Business Corporation Law

§ 726 empowers corporations to purchase D & 0 insurance for several purposes:(1) to indemnify the corporation for its obligation to indemnify directors andofficers; (2) to indemnify directors and officers where the corporation permits theirindemnification; and (3) to indemnify directors and officers in instances where thecorporation fails to indemnify them. N.Y. Bus. CORP. LAW § 726 (McKinney &West Supp. 1987). This Note concerns D & 0 insurance under categories 2 and3.

11. See Johnston, supra note 1, at 2012.12. See id.; Note, Liability Insurance for Corporate Executives, 80 HARV. L.

REV. 648, 648 (1967) [hereinafter Corporate Executives].13. F. WORSLEY & G. GRIFFITH, THE ROMANCE OF LLOYD'S 13-14 (1932).14. See Johnston, supra note 1, at 2012.15. See id. (citing Brockmeier, Status of D & 0 Liability Coverage, RISK MGMT.

MAO. 20 (Jan. 1977)); see also Continental Casualty Co. v. Board of Education,302 Md. 516, 529, 489 A.2d 536, 542 (1985).

16. See Goldstein & Gordon, supra note 1, at 2.17. See id.; Johnston, supra note 1, at 2023; Oettle & Howard, supra note 1,

at 339.18. See Goldstein & Gordon, supra note 1, at 2; Johnston, supra note 1, at

2023; Oettle & Howard, supra note 1, at 339; D. DEY & S. RAY, ANNOTATED

COMPREHENSIVE GENERAL LIABILITY INSURANCE POLICY 53 (Defense Research In-stitute, Inc. 1984) [hereinafter LIABILITY INSURANCE]. In the typical D & 0 policy

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most D & 0 insurance provisions are standardized, 19 courts differas to when the insurer must disburse these payments. 2° Specifically,there is a dispute concerning whether the standard D & 0 insurancepolicy2' requires the insurer to pay the insured's defense costs asthey accrue2 2 despite policy language providing that this duty doesnot arise until final adjudication of the underlying claims againstthe insured. 23 This timing issue arises because attorneys' fees andexpenses usually come due before final adjudication,2 and becauseone cannot immediately determine whether the cost of the defensewill ultimately fall within policy coverage. 25

While some jurisdictions have held that the standard D & 0 policyrequires the insurer to reimburse defense costs 26 as they accrue,"2

insuring clause, the insurer agrees to pay on behalf of each director or officer anyloss (as the term is defined in the policy) arising from claims made against themby reason of any wrongful act (as the term is defined in the policy) committedin their respective capacities of directors or officers. See Johnston, supra note 1,at 2015.

19. See J. KEETON, INSURANCE LAW 72 (1971) [hereinafter KEETON]. Theseprovisions include such clauses as the "option" clause, the "no action" clause andthe "consent to costs" clause. See generally Oettle & Howard, supra note 1, at339-40.

20. The dilemma arises because the D & 0 insuring clause seems to indicatethat payments will be made as losses are incurred, while the option clause seemsto require disbursement only after adjudication. For a lucid description of thedilemma, see Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1462 (W.D. Pa.1986), aff'd, 836 F.2d 789 (3d Cir. 1987).

21. For an analysis of the components of the typical D & 0 insurance policy,see Oettle & Howard, supra note 1, at 337-40. Lloyd's D & 0 policy is the onemost widely used. See Practical Aspects, supra note 1, at 699 n.83; CorporateExecutives, supra note 12, at 649-50.

22. In this Note, the phrase "as they accrue" is synonymous with "as incurred"when describing the payment of legal expenses.

23. See Goldstein & Gordon, supra note 1, at 2; Johnston, supra note 1, at2023; Oettle & Howard, supra note 1, at 337.

24. See Pepsico, Inc. v. Continental Casualty Co., 640 F. Supp. 656, 659(S.D.N.Y. 1986) (citing Okada v. MGIC Indem. Corp., 608 F. Supp. 383, 385 (D.Haw. 1985), aff'd in part, rev'd in part, 795 F.2d 1450 (9th Cir. 1986)).

25. See Oettle & Howard, supra note 1, at 338. The typical D & 0 policycontains several important statutory exclusions and some "non-standard" exclusions,added to the policy by the insurers, which limit coverage. See Johnston, supranote 1, at 2017. One particularly popular exclusion, the "dishonesty exclusion,"excludes liability "with respect to claims brought about or contributed to by thedishonesty of the insureds ...... Id. at 2019. Usually, however, a claimant'sdishonesty is not established until adjudication. Consequently, insurers prefer tocover defense costs after a final adjudication and not on an "as incurred" basis.

26. "Defense costs" is not entirely synonymous with "legal expenses." Forpurposes of this Note, however, the terms are used interchangeably.

27. See Okada v. MGIC Indem. Corp., 608 F. Supp. 383, 385 (D. Haw. 1985),aff'd in part, rev'd in part, 795 F.2d 1450 (9th Cir. 1986); Pepsico, Inc. v.

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others have held that the insurer has the right to await a finaladjudication. 28 Each view has widely divergent consequences. Theformer redounds to the detriment of insurers, 29 while the latter worksagainst insureds and the institutions they represent.3 0 In resolvingsuch a contractual dilemma, courts examine the plain meaning ofthe policy language," rules of contract interpretation3 2 and principlesof unconscionability. 3

In the Southern District of New York, a recent case, Pepsico,Inc. v. Continental Casualty Co. i

4 held that the D & 0 insurancecarrier was obligated to pay the insured's costs as they accrue,35

subject to reimbursement should adjudication show that there wereno grounds for coverage. 6

This Note proposes that the Pepsieo rule favoring the insured isthe more judicious view regarding interim payments. Part Ii discusses

Continental Casualty Co., 640 F. SUpp. 656, 659-60 (S.D.N.Y. 1986); Little v.MOIC Indem. Corp., 649 F. Supp. 1460, 1465 (W.D. Pa. 1986), aff'd, 836 F.2d789 (3d Cir. 1987).

28. See Clandening v. MGIC Indem. Corp., No. CV 83-2432 (C.D. Cal. May24, 1983); California Chiropractic Ass'n v. CNA Ins. Co., No. C-579-326 (Sup.Ct. Los Angeles County June 26, 1986); Enzweiler v. Fidelity & Deposit Co., No.85-99 (E.D. Ky. May 13, 1986); Luther v. Fidelity & Deposit Co., No. 85-2762-Civ.-JWK (S.D. Fla. Aug. 15, 1986); First Fed. Sav. and Loan Ass'n v. MGICIndem. Corp., No. 32-2121 (D.N.J. Sept. 3, 1982); Citizens State Bank v. MGICIndem. Corp., No. L-050357-84 (N.J. Super. Ct. Law Div. June 28, 1985); Bankof Commerce & Trust Co. v. National Union Fire Ins. Co., 651 F. Supp. 474,476-77 (N.D. Okla. 1986).

29. For a discussion of the woes confronting insurers in the face of the formerview, see Practical Aspects, supra note 1, at 714 n.163 (given time value of moneyinsurer would rather pay later than sooner; also, insurer risks loss if he advancesdefense costs to non-covered director).

30. The detrimental impact on insureds of defense cost reimbursement at theconclusion of trial is noted in Johnston, supra note 1, at 1993-94.

31. See Omaha Indem. Co. v. Johnson & Towers, Inc., 599 F. Supp. 215(D.C.N.Y. 1984); Libra Bank Ltd. v. Banco Nacional De Costa Rica, S.A., 570F. Supp. 870 (D.C.N.Y. 1983); In re Estate of Olson, 447 Pa. 483, 488, 291 A.2d95, 98 (1972) (quoting Orner v. T. W. Phillips Gas & Oil Co., 401 Pa. 195, 199,163 A.2d 880, 883 (1960)); Pennsylvania Mfrs.' Ass'n Ins. Co. v. Aetna Casualty& Surety Ins. Co., 426 Pa. 453, 457, 233 A.2d 548, 551 (1967).

32. See Okada, 795 F.2d at 1453-55; Little, 649 F. Supp. at 1463; Pepsico,640 F. Supp. at 659-60; Mohn v. American Casualty Co., 458 Pa. 576, 586, 326A.2d 346, 351 (1974).

33. See Standard Venetian Blind Co. v. American Empire Ins., 503 Pa. 300,307, 469 A.2d 563, 567 (1983); Witmer v. Exxon Corp., 495 Pa. 540, 551, 434A.2d 1222, 1228 (1981) (quoting Williams v. Walker-Thomas Furniture Co., 350F.2d 445, 449 (D.C. Cir. 1965)).

34. 640 F. Supp. 656 (S.D.N.Y. 1986).35. Id. at 659-60.36. Id. at 660.

D & 0 INSURANCE

the differing interpretations of D & 0 policy defense cost clauses.Part III puts forth the Pepsico rule, a view in support of the insured.Part IV analyzes the Pepsico rule from the standpoints of reasonableexpectations, contract interpretation and unconscionability, and, aftercomparing D & 0 insurance with standard liability insurance, rec-ommends adoption ot the Pepsico rule in other jurisdictions.

II. Differing Interpretations of Defense Cost Clauses

Case law on the timing of insurance disbursement falls along twolines: that which obligates the insurer to pay the defense costs asincurred (the pro-insured argument), and that which grants the insurerthe right to await a final adjudication (the pro-insurer argument).37

A. The Pro-Insured Argument

In Okada v. MGIC Indemnity Corp. ," the defendant, an insurancecompany, issued a D & 0 liability insurance policy to the plaintiffs,insured directors and officers of First Savings and Loan.3 9 Theplaintiffs, defendants in two underlying cases4° wherein they werealleged to have caused First Savings and Loan to become insolvent, 41

sought a declaratory judgment to construe the terms of the D & 0policy. 42 At issue was whether MGIC Indemnity Corporation (MGIC)had to pay the attorneys' fees of the plaintiffs as incurred.4 3 MGIC'sprimary argument was that the option clause of the D & 0 insurancepolicy relieved it of the duty to advance legal expenses. 44 Thisprovision reserved for the insurer the option to advance defensecosts to the insured. 45 The District Court of Hawaii held that the

37. "The pro-insured argument" and "the pro-insurer argument" are termscreated for this Note.

38. 608 F. Supp. 383 (D. Haw. 1985), aff'd in part, rev'd in part, 795 F.2d1450 (9th Cir. 1986).

39. Id. at 385.40. The two underlying suits were FLSIC v. Alexander, 590 F. Supp. 834 (D.

Haw. 1984), and First Hawaiian Bank v. Alexander, 558 F. Supp. 1128 (D. Haw.1983). Okada, 608 F. Supp. at 385.

41. Id.42. Id. A party seeks declaratory relief to obtain a declaration of rights so that

he understands what he can and cannot legally do. See D. DoBBS, REmEDIES 26(West 1973).

43. See Okada, 608 F. Supp. at 385.44. See id. at 386.45. Section 5(c) of the policy contained the following provision:

The insurer may at its option and upon request, advance on behalf ofthe [d]irectors and [o]fficers, or any of them, expenses which they have

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option clause was inconsistent with the definition of loss in thepolicy, 46 thus creating an ambiguity which, under Hawaii law, wasto be construed against the drafter/insurer.4 7 The court added thata D & 0 insurance policy like the one described by MGIC wouldbe virtually impossible to vend to reasonable directors and officers4

and that an insurance policy "should be construed according to thereasonable expectations of the insured." ' 49 On appeal, the NinthCircuit affirmed the district court's holding that MGIC was obligatedto pay plaintiff's defense costs as they came due.5 0

In Little v. MGIC Indemnity Corp.," the United States DistrictCourt for the Western District of Pennsylvania ruled against thedefendant insurance company using a similar rationale. Union Na-tional Bank of Pittsburgh (UNB) purchased a D & 0 policy forthe benefit of its directors and officers. 2 The policy was issued byMGIC Indemnity Corporation (MGIC). Beginning in 1983, UNBwas named as a defendant in several lawsuits brought by five otherinstitutions.14 James P. Little (Little), vice-president of UNB's com-mercial loan department, was named as a third-party defendant ineach of the lawsuits.5 MGIC refused to advance defense costs to

incurred in connection with claims made against them, prior to dispositionof such claims, provided always that in the event it is finally establishedthe [i]nsurer has no liability hereunder, such [dlirectors and [ojfficersagree to repay to the [ilnsurer, upon demand, all monies advanced byvirtue of this provision.

Id. (emphasis added),46. Id. Section I(d) of the policy defines "loss" as follows:

The term "[lioss" shall mean any amount which the [dlirectors and[o]fficers are legally obligated to pay or for which the [a]ssociation isrequired to indemnify the [d]irectors or [o]fficers ... for a claim orclaims made against the [dlirectors and [o]fficers for [wlrongful [a]ctsand shall include but not be limited to damages, judgments, settlements,costs . . . and defense of legal actions ....

Id. at 385.The court noted an additional ambiguity in the policy-between § 5(c), supra

note 45, and § 5(a). Section 5(a) provides in pertinent part: "No costs, chargesand expenses shall be incurred or settlements made without the [i]nsurer's consent...." Okada, 608 F. Supp. at 386.

47. See id.48. See id. at 387.49. Id. (citing Sturla, Inc. v. Fireman's Fund Ins. Co., 67 Haw. 203, 210, 684

P.2d 960, 964 (1984)).50. See Okada v. MGIC Indem. Corp., 795 F.2d 1450, 1454 (9th Cir. 1986).51. 649 F. Supp. 1460 (W.D. Pa. 1986), aff'd, 836 F.2d 789 (3d Cir. 1987).52. Id. at 1461.53. Id.54. Id. at 1462. For a list of the underlying suits, see id. at 1462 n. 1.55. Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1461-62 (W.D. Pa. 1986),

aff'd, 836 F.2d 789 (3d Cir. 1987).

1988] D & 0 INSURANCE

Little, arguing that the D & 0 policy provided the insurer the optionto advance such costs at its discretion.16 Little, consequently, soughta declaratory judgment ordering MGIC to pay the defense costsassociated with the other lawsuits.17 The court herd that because thelanguage of the D & 0 policy was ambiguous58 MGIC was obligatedto pay Little's defense costs in the underlying suits as those costswere incurred. 9 Under Pennsylvania law, ambiguities are resolvedagainst the insurer. ° The court, therefore, held for the plaintiff.61

The court further proffered that even if the language of the D &O policy unambiguously granted the insurer an absolute option towithhold defense costs until a final adjudication, such a provisionwould be unconscionable under Pennsylvania law. 62 This is because"it leaves the insured no meaningful choice in the matter ... hehas no real alternative even though the cost of defense may bankrupthim,''63 and "it is unreasonably favorable to the insurers, who mayblithely disclaim responsibility for the insured's enormous financialburdens while the insured must fight on."6

B. The Pro-Insurer Argument

Other jurisdictions hold that the standard D & 0 policy does notobligate the insurer to pay defense costs as incurred.6 5 In Luther v.

56. Id. at 1462.57. Id.58. See id. at 1469.59. The court noted the following ambiguities:

There are two ambiguous parts to the D & 0 policy ... [s]ubsection5(C) creates confusion by seeming to absolve the insurer from its dutyto pay reasonable defense costs contained in [s]ubsection 5(A) ....Another ambiguity is apparent when [s]ection 3(A)(5) is read in con-junction with [slection 5.

Id. at 1465.60. See Mohn v. American Casualty Co., 458 Pa. 576, 586, 326 A.2d 346, 351

(1974).61. Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1466, 1469 (W.D. Pa.

1986), aff'd, 836 F.2d 789 (3d Cir. 1987).62. See id. at 1468.63. Id. There are three reasons why the insured has no choice but to accept

the coverage offered him. First, the exposure to tremendous liability generates anurgent need for some kind of D & 0 coverage. See infra notes 121-27 andaccompanying text. Second, the small market for D & 0 insurance limits opportunityto shop for bargains. See supra note 16 and accompanying text. Third, standard-ization of D & 0 policy provisions renders the existence of alternative insurersmoot. See infra notes 154-66 and accompanying text.

64. Little, 649 F. Supp. at 1648.65. See supra note 28 and accompanying text.

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Fidelity & Deposit Co.,66 for example, the court refused to forcean insurance carrier to pay insured directors and officers interimpayments67 for their defense costs. 68 The United States District Courtfor the Southern District of Florida found that the policy's optionclause, the crux of the dispute, was plain and unambiguous on itsface.6 9 It undeniably granted the insurer an option to advance pay-ments to the insured.70 Consequently, the policy required no specialconstruction or interpretation. 7

1

In Continental Casualty Co. v. Board of Education,72 insuredmembers of the Charles County Board of Education sought con-struction of a D & 0 insurance policy issued by Continental CasualtyCompany (CCC).73 Although the issues before the court did notspecifically include the "as incurred" question,7 4 the court did discussthe validity of the policy's option clause. 7 After a detailed analysisof the D & 0 policy,76 the majority noted that the clause's languagegave CCC "the option, but not the obligation" to disburse paymentsfor legal costs as incurred.7 7 The court found support for its positionin the plain meaning of the option clause language78 and one com-

66. No. 85-2762-Civ.-JWK (S.D. Fla. Aug. 15, 1986).67. See supra note 8.68. Luther v. Fidelity & Deposit Co., No. 85-2762-Civ.-JWK (S.D. Fla. Aug.

15, 1986); see also Clandening v. MGIC Indem. Corp., No. CV 83-2432 (C.D.Cal. May 24, 1983).

69. "The language contained therein clearly reflects that [the insurer], if it sochooses, may advance expenses . .. [but] is not obligated to do so . . . ." Lutherv. Fidelity & Deposit Co., No. 85-2762-Civ.-JWK (S.D. Fla. Aug. 15, 1986) (emphasisadded).

70. See id.71. See id.72. 302 Md. 516, 489 A.2d 536 (1985).73. Id. at 520, 489 A.2d at 538.74. The court of appeals considered five certified questions, none of which

specifically concerned whether the insurer must disburse D & 0 insurance paymentson an "as incurred" basis. See id. at 531-37, 489 A.2d at 543-47.

75. The policy contained the typical option clause language. Id. at 522, 489A.2d at 539. See infra note 78 for the pertinent text of the option clause. Forfurther discussion of option clauses in general, see Oettle & Howard, supra note1, at 339-40.

76. See Continental, 302 Md. at 520-22, 489 A.2d at 538-39.77. Id. at 530, 489 A.2d at 543 (emphasis added).78. The option clause contained the following provision:

(b) The [ilnsurer may at its option and upon request, advance on behalfof an [a]ssured . .. fees, costs and expenses which have been incurredin connection with claims made against an [a]ssured, prior to dispositionof such claims, provided always that, in the event it is finally establishedthe [i]nsurer has no liability hereunder, each agrees to repay to the[ilnsurer, upon demand, all monies advanced on their behalf pursuant

D & 0 INSURANCE

mentator's description of D & 0 insurance: "Under D & 0 policiesthe insured must provide its defense, although the insurer mayparticipate at its [own] option . . .,,9

In Bank of Commerce and Trust Co. v. National Union FireInsurance Co.,80 the insureds sought declaratory relief concerning aD & 0 insurance policy. 8 The United States District Court ofOklahoma denied both parties' motion for summary judgment, hold-ing that there were "genuine issues of material fact to be resolved." 82

Although the court did not decide the "as incurred" issue explicitly, 8

it did observe that a final adjudication in the underlying suit couldshow that the directors and officers were disqualified from coverage.84

Accordingly, this case stands for the proposition that coverage fordefense costs is a function of underlying claims.85 Because coveragecannot be established absolutely until a final adjudication of theunderlying claims,86 it would appear, under the view espoused inBank of Commerce, that an insurer has no obligation to reimbursethe insured's defense costs as incurred.8 7

In Enzweiler v. Fidelity & Deposit Co.,88 the District Court ofKentucky was more explicit. In Enzweiler, Fidelity & Deposit Com-pany of Maryland (Fidelity) issued a D & 0 policy to Ervin Enzweiler(Enzweiler), president of Northern Kentucky Bank & Trust(Northern).8 9 Enzweiler became involved in a number of suits arisingout of his conduct as president of Northern, and sought a declaratoryjudgment as to whether Fidelity was required to make paymentsunder the D & 0 policy. 90 The court held that the insurance companycould elect to await the outcome of the underlying claims against

to this provision.Id. at 522, 489 A.2d at 539 (emphasis added).

79. Id. at 530, 489 A.2d at 543 (citing W. KNEPPER, LIABILITY OF CORPORATE

OFrlCERS AND DmECTORS ch. 20 (3d ed. 1978)).80. 651 F. Supp. 474 (N.D. Okla. 1986).81. Id. at 475. For an explanation of declaratory relief, see supra note 42.82. Bank of Commerce, 651 F. Supp. at 476.83. The court noted that the "as incurred" issue remained moot until it was

determined whether the insured's alleged actions fell within the policy's coverage.Id. at 476-77.

84. See id. at 476.85. See id.; see also Oettle & Howard, supra note 1, at 343.86. See Oettle & Howard, supra note 1, at 344.87. It is impossible to permit the insurer to await a final adjudication on the

one hand, and obligate him to pay costs as incurred on the other.88. Civ. No. 85-99 (E.D. Ky. 1986).89. Id.90. Id.

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Enzweiler before advancing any payments. 9' While placing emphasison the plain meaning of the option clause provision in the D & 0policy, 92 the court also reasoned that the judgment in the underlyingactions "may be such that there is no coverage." 93

III. The Pepsico Rule

In Pepsico, Inc. v. Continental Casualty Co., the Southern Districtof New York adopted a position similar to that of the "pro-insured"jurisdictions. The decision obligates insurers to pay an insured'sdefense costs as incurred, 94 but stipulates, however, that such pay-ments are made subject to reimbursement 95 should final adjudicationshow that there were no grounds for coverage. 96

In Pepsico, plaintiff Pepsico, Inc. (Pepsico) purchased a D & 0insurance policy from Continental Casualty Company (Continental). 97

Pepsico sought to recover from Continental money paid in litigationinvolving Pepsico's directors and officers. 9 Pepsico argued that Con-tinental had a duty to pay the defense costs to the directors andofficers on an "as incurred" basis. 99 Continental countered that itwas not liable to pay the legal fees until final adjudication becausethere remained the possibility that a final adjudication would revealthat the directors and officers had disqualified themselves fromcoverage.100 Consequently, Continental moved to dismiss the com-plaint. 101

91. Id.92. See id. at 1.93. Id.94. See Pepsico, Inc. v. Continental Casualty Co., 640 F. Supp. 656 (S.D.N.Y.

1986). For a discussion of the pro-insured argument, see supra notes 38-64 andaccompanying text. There are relatively few decided cases on point, but Pepsicoclearly and concisely sets out the rule.

95. See Pepsico, 640 F. Supp. at 659.96. Insurers frequently raise the possibility that the recipients of the insurance

payments are not covered by the policy. See Little v. MGIC Indem. Corp., 649F. Supp. 1460, 1466 (W.D. Pa. 1986), aff'd, 836 F.2d 789 (3d Cir. 1987). Thisargument is referred to as the "no-coverage objection."

97. Pepsico, 640 F. Supp. at 657.98. Id.99. Id. at 658.

100. Paragraph IVb(5) of the D & 0 policy excluded coverage for payments"brought about or contributed to by the dishonesty of the [d]irectors or [o]fficers."Id. at 659.

101. Id. at 657.

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The court held that the D & 0 policy language did not excuseContinental from its obligation to pay the defense costs as incurred.10 2

The court looked primarily to the plain meaning of the terms ofthe D & 0 policy,103 which contained, inter alia, a dishonesty ex-clusion clause." °4 Nowhere in the policy, the court observed, wasentry of final judgment made a prerequisite to payment of defensecosts. 105 Furthermore, according to the D & 0 policy definition ofloss'0 6 the insurer's duty to pay all defense costs attached once thedirectors and officers were legally obligated to pay them. 0 7 It thenbecame incumbent upon Continental to confine its duty to pay,10 8

which it could do "only if it could establish as a matter of lawthat there was no possible factual basis on which it might be obligatedto indemnify the directors and officers."' ° Since Pepsico's directorswere "legally obligated to pay" their legal expenses "as incurred,"Continental was required to cover this loss on an "as incurred"basis. 110

IV. Courts Should Adopt the Pepsico Rule

The Pepsico rule is justified on the grounds of reasonable ex-pectations, rules of contract interpretation and principles of uncon-scionability."' Furthei, alternative support for the rule is found byanalogizing D & 0 insurance to standard liability insurance."12

A. The Parties' Reasonable Expectations

Where possible, the words of an insurance policy are to be giventheir plain, ordinary meaning." 3 This rule, derived from the linguistic

102. Id. at 659. The court also noted that Continental would be entitled toreimbursement should final adjudication show that no coverage existed in the firstplace. Id.

103. See id. at 660-61.104. "The policy excludes coverage for any payments 'brought about or con-

tributed to by the dishonesty of the [d]irectors or [oifficers.' "Id. at 659.105. Id.106. "Loss shall mean any amount which the [d]irectors and [olfficers are legally

obligated to pay . . . [including] amounts incurred in the defense of legal actions,claims or proceedings and appeals therefrom .... " Id.

107. See id.108. See id. at 660.109. Id. (citing Villa Charlotte Bronte, Inc. v. Commercial Union, 64 N.Y.2d

846, 848, 476 N.E.2d 640, 642, 487 N.Y.S.2d 314, 316 (1985)).110. The Okada court made the same point. See Okada v. MGIC Indem. Corp.,

608 F. Supp. 383, 386 (D. Haw. 1985), aff'd in part, rev'd in part, 795 F.2d 1450(9th Cir. 1986).

111. See supra notes 31-33 and accompanying text.112. See infra notes 172-93 and accompanying text.113. See C. Raymond Davis & Sons, Inc. v. Liberty Mutual Ins. Co., 467 F.

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FORDHAM URBAN LA W JOURNAL [Vol. XVI

formalism of the old British courts," 4 is concisely summed up byProfessor Wigmore: "You cannot disturb a plain meaning." '" 5

From judicial regulation of adhesion contracts, 16 however, emergesone broad principle: "The objectively reasonable expectations ofapplicants and intended beneficiaries regarding the terms of insurancecontracts will be honored even though painstaking study of thepolicy provisions would have negated those expectations.""17 Thisdoctrine puts forth an objective method of achieving equity betweeninsurer and insured." 8 It signifies that the standard for policy in-terpretation is that of the layman, not the sophisticated underwriter."l9

The crucial question to be resolved, therefore, is whether a D & 0policyholder could reasonably expect defense costs to be underwrittenas incurred.12 0

A director's legal costs can be enormous, 2' and his legal battlescan last for years. 2 2 Directors are exposed to the possibility ofdefense costs "far in excess of anything that has been experiencedhistorically."' 12a According to a 1982 Wyatt Company D & 0 in-surance survey, 124 for example, the average total cost per policy claimamounted to $365,O000.25 Even claims that were eventually dropped

Supp. 17, 20 (E.D. Pa. 1979) (citing Easton v. Washington County Ins. Co., 391Pa. 28, 137 A.2d 332 (1958)).

114. See 9 J. WIGMORE, EVIDENCE § 2461, at 197 (1983).115. Id.116. An adhesion contract is a standardized contract form offered to consumers

without affording the consumer a realistic opportunity to bargain. BLACK'S LAW

DICTIONARY 38 (5th ed. 1979). For the origin of the term see Patterson, The Deliveryof a Life-Insurance Policy, 33 HARV. L. REV. 198, 222 (1919).

117. KEETON, supra note 19, at 351 (emphasis added).118. Id.119. See id.; see also Steven v. Fidelity & Casualty Co., 58 Cal. 2d 862, 869-

70, 377 P.2d 284, 288-89, 27 Cal. Rptr. 172, 176-77 (1962).120. See Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1465-66, aff'd, 836

F.2d 789 (3d Cir. 1987).121. See supra note 6 and accompanying text; see, e.g., Little, 649 F. Supp. at

1468; J. BISHOP, THE LAW OF CORPORATE OFFICERS AND DIRECTORS: INDEMNIFICATIONAND INSURANCE 1.01 (1981).

122. See supra note 7 and accompanying text. Eisen v. Carlisle & Jacquelin, 417U.S. 156 (1974), a D & 0 liability suit that exemplifies the indeterminate amountof time during which a director may be forced to cover his defense costs, generatedsix years of legal fees. See Knepper, An Overview of D & 0 Liability for InsuranceCompany Directors and Officers, 45 INS. COUNS. J. 63 (1978).

123. Johnston, supra note 1, at 1993.124. The Wyatt Company is a consulting firm specializing in pension plans,

actuarial evaluations, risk management, employee benefits and executive compen-sation. See Practical Aspects, supra note 1, at 692.

125. See id. at 694 (citing THE WYATT COMPANY, 1982 COMPREHENSIVE REPORT:

DIRECTORS AND OFFICERS LIABILITY/ FIDUCIARY LIABILITY 14 (1982)).

D & 0 INSURANCE

cost directors an average of $70,000 in legal expenses. 2 6 Clearly,the threat of potentially crippling legal costs is the primary reasondirectors obtain D & 0 liability insurance.2 7

In fact, the only notice a policyholder might have that he maybe forced to underwrite his entire defense is the language of theoption clause in the D & 0 policy, 128 a clause often cited in opinionsfor its ambiguity and vagueness. 2 9 Certainly, the split of authorityon the clarity of the clause is some indication that the option clauselanguage is less than clear. 30

A D & 0 policyholder, therefore, would reasonably expect defensecosts to be underwritten as incurred.' Indeed, a D & 0 policy thatprovided otherwise "would not truly protect the individual fromfinancial harm.'1 2 It would leave the insured in an extremely vul-nerable position,' as few directors are likely to possess the resourcesto sustain such costs.'3 4 Consequently, a reasonable director or officerwould almost never purchase a D & 0 policy that did not coverlegal costs as incurred."

B. Rules of Contract Interpretation

Ordinary rules of contract interpretation also demonstrate thevalidity of the Pepsico rule. 36 Most insurance policy provisions aredrafted by the insurer.'37 If a provision in an insurance contract isambiguous, or inconsistent with another provision, it is construedin favor of the insured and against the insurer.' 8 The primary

126. See Practical Aspects, supra note 1, at 694.127. See Goldstein & Gordon, supra note 1, at 2.128. See supra note 45 for the typical option clause language.129. See, e.g., Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1465, aff'd,

836 F.2d 789 (3d Cir. 1987); Okada v. MGIC Indem. Corp., 608 F. Supp. 383,387 (D. Haw. 1985), aff'd in part, rev'd in part, 795 F.2d 1450 (9th Cir. 1986);Okada, 795 F.2d at 1453-54.

130. See Little, 649 F. Supp. at 1466.131. See supra notes 48-49 and accompanying text.132. Okada, 608 F. Supp. at 387.133. See id.; Little, 649 F. Supp. at 1468-69; Practical Aspects, supra note 1,

at 691 ("uneasy lies the corporate head unprotected by a solid D & 0 policy").134. See Johnston, supra note 1, at 1993.135. See Little, 649 F. Supp. at 1466; Okada, 608 F. Supp. at 387.136. See supra note 32 and accompanying text.137. See KEETON, supra note 19, at 350.138. See Westchester Resco Co., L.P. v. New England Reinsurance Corp., 818

F.2d 2 (2d Cir. 1987); Stern v. Satra Corp., 539 F.2d 1305 (2d Cir. 1976); VanEkris & Stoett, Inc. v. S.S. Rio Paraguay, 573 F. Supp. 1475 (D.C.N.Y. 1983),

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FORDHAM URBAN LA W JOURNAL [Vol. XVI

rationale is that purchasers of insurance generally possess a less thancomplete mastery of the nuances of their policy' a9 and thereforeshould be protected from "the fine print" of long and complicatedforms. 140

This is no less true in the case of purchasers of D & 0 insurance.D & 0 policies granting the insurer an option to withhold defensecosts until adjudication, i.e., policies with the typical option clause,are often found to contain ambiguous or conflicting clauses.14' Thisis due to the problematic nature of a policy construction favoringthe insurer-i.e., finding that an insured's accruing defense costsare not "losses" under the. policy142-and a perceptible attempt bythe courts to "do equity" by straining to find ambiguities in D &O policies.'

4

Insurers contend, however, that directors are sufficiently intelligentto recognize policy ambiguities on their face.'" Purchasers of D &O insurance, insurers argue, are more sophisticated than the averageconsumer in bargaining for insurance coverage. 145 At least one courthas found, however, that directors require the same judicial pro-tection from policy ambiguities as ordinary consumers.' 46 Indeed,the doctrine of construing ambiguities against the drafter is "morerigorously applied in insurance than in other contracts, in recognition

aff'd, 738 F.2d 419 (2d Cir. 1984); see also Okada v. MGIC Indem. Corp., 608F. Supp. 383, 386 (D. Haw. 1985), aff'd in part, rev'd in part, 795 F.2d 1450(9th Cir. 1986); Pacific Indem. Co. v. Linn, 766 F.2d 754, 761 (3d Cir. 1985);Allen Spooner & Son. Inc. v. Connecticut Fire Ins. Co., 314 F.2d 753, 755 (2dCir.), cert. denied, 375 U.S. 819 (1963); Mohn v. American Cas. Co., 458 Pa.576, 586, 326 A.2d 346, 351 (1974); Gray v. Zurich Ins. Co., 65 Cal. 2d 263,269, 419 P.2d 168, 171, 54 Cal. Rptr. 104, 107 (1966). This is known as thedoctrine of contra proferentem. See W. YOUNG & E. HOLMES, INSURANCE 56-65(2d ed. 1985).

139. See KEETON, supra note 19, at 351-52.140. See id.141. See supra notes 128-30 and accompanying text.142. One commentator illustrates this problem in a discussion of the Okada

court's reasoning:[Loss] is defined to include "any amount which the [dlirectors and[ojfficers are legally obligated to pay .... ." The court reasoned thatthe insured is "legally obligated to pay" defense costs as they come due(in the sense that the insured's counsel has submitted a bill). Thus, thecourt concluded, a "loss" covered by the policy is sustained at the timedefense costs are incurred.

Oettle & Howard, supra note 1, at 347.143. See 11 G. COUCH, COUCH ON INSURANCE § 44:6 (rev. ed. 1982); KEETON,

supra note 19, at 356.144. See Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1469 (W.D. Pa.

1986), aff'd, 836 F.2d 789 (3d Cir. 1987).145. See id.146. See id.

1988] D & 0 INSURANCE 481

of the difference between the parties in their acquaintance with thesubject matter. "141

C. Unconscionability

Can an insurer escape the noose of the Pepsico rule by includingin its D & 0 policy an unambiguous, clear provision disclaimingobligation to pay on an "as incurred" basis? If the D & 0 policyis unambiguous the court must give effect to that language. 48 There-fore, justification for deviating from unambiguous D & 0 policylanguage lies only in principles of unconscionability, 149 which ensurethat an insurer will not be permitted an unconscionable advantagein an insurance transaction despite fully informed consent on thepart of the insured. 50 The crucial question, then, is whether it wouldbe unconscionable to force policyholders to underwrite their ownlegal defense costs for an indeterminate period of time. 5'

The basic test of unconscionability is whether the clauses involvedin the D & 0 policy are so one-sided as to oppress or unfairlysurprise the other party. 15 2 That is, does the standard D & 0 policyinclude: (1) an absence of meaningful choice on the part of one ofthe parties; and (2) terms which are unreasonably favorable to theother party?'

D & 0 policies are contracts of adhesion. 154 An insurer generallyoffers a limited range of insurance forms'55 and the purchaser must

147. Gaunt v. John Hancock Mutual Life Ins. Co., 160 F.2d 599, 602 (2d Cir.)(emphasis added), cert. denied, 331 U.S. 849 (1947).

148. See New York v. Home Indem. Co., 106 A.D.2d 124, 483 N.Y.S.2d 834(3d Dep't), aff'd, 66 N.Y.2d 669, 486 N.E.2d 827, 495 N.Y.S.2d 969 (1985);Jewish Bd. of Family and Children's Servs., Inc. v. City of New York, 66 N.Y.2d710, 487 N.E.2d 283, 496 N.Y.S.2d 426 (1985). See generally 4 S. WILISTON, ATREATISE ON THE LAW OF CONTRACTS § 602A, at 325-34 (3d ed. 1961).

149. See Standard Venetian Blind Co. v. American Empire Ins., 503 Pa. 300,307, 469 A.2d 563, 567 (1983) (citing 13 PA. CONST. STAT. § 2302) (court mayrefuse enforcement of contract or particular clause if unconscionable at time ofdrafting); Oettle & Howard, supra note 1, at 348.

150. See KEETON, supra note 19, at 348.151. See Little, 649 F. Supp. at 1468.152. J. CALAMARI & J. PERILLO, CONTRACTS 406 (2d ed. 1986) [hereinafter

CALAMARI & PERILLO]. The concept of unconscionability has entered the generallaw of contracts. Id. at 403.

153. Id. at 407.154. See KEETON, supra note 19, at 350. "There has been increasing recognition

... that the bargaining process has become more limited in modern society ....[The consumer faced with an adhesion contract] has no real choice. He must takethat form or leave it." CALAMARI & PERILLO, supra note 152, at 6.

155. See KEETON, supra note 19, at 73.

FORDHAM URBAN LA W JOURNAL [Vol. XVI

accept one if he desires coverage. 56 The major advantage this offersthe insurer is economy of operations.' 57 By drafting standardizedinsurance policies insurers avoid the cost of negotiating insuranceon a policy-by-policy basis.' 58 Insurers contend that the public alsobenefits from standardization. 5 9 The standardized policy is developedfrom experience, they argue, and is therefore a fair approximationof a policyholder's needs.'16

An insured, nonetheless, has "little choice beyond electing amongstandardized provisions offered to him.'' 1 Standardized provisions,though, limit the "scope of choice" of the insurance purchaser. 62

Essentially, there exists an inequality in bargaining power betweenvendors and purchasers of insurance policies. 63 Purchasers of D &O insurance "have no more leverage than the ordinary person whodeals with insurance companies"' 64 because they also cannot bargainfor the terms of the policy. 65 The insured, therefore, faces an absenceof meaningful choice when purchasing D & 0 liability insurance. 66

Furthermore, a D & 0 policy that grants the insurer an absoluteoption to withhold defense costs is unreasonably favorable to theinsurer. 67 The insurer could defer all payments until adjudication;' 68

this is usually for an indeterminate amount of time. 69 Moreover,the D & 0 policy would allow the insurer the luxury of deferringpayments in virtually every case. 70 Finally, the policy would provequite unfavorable to the insured, as it would leave him in a financially

156. See id.157. See id. at 69.158. See id.159. See id.160. See id.161. Id. at 350. The bargaining process with regard to adhesion contracts "is

not one of haggle or cooperative process but rather of a fly and flypaper." CALAMARI& PERLLO, supra note 152, at 6 (quoting Leff, Contract as Thing, 19 AM. U.L.REV. 131, 143 (1970)).

162. See KEETON, supra note 19, at 69.163. See id. at 348; see also Standard Venetian Blind Co. v. American Empire

Ins., 503 Pa. 300, 304, 469 A.2d 563, 567 (1983).164. Little v. MGIC Indem. Corp., 649 F. Supp. 1460, 1469 (W.D. Pa. 1986),

aff'd, 836 F.2d 789 (3d Cir. 1987).165. See id.; see also KEETON, supra note 19, at 72-73.166. The small number of insurers willing to carry D & 0 insurance exacerbates

the absence of meaningful choice. See supra note 16 and -accompanying text.167. See supra note 64 and accompanying text; see also Practical Aspects, supra

note 1, at 714 n.163.168. See Little, 649 F. Supp. at 1468; Goldstein & Gordon, supra note 1, at 2;

Johnston, supra note 1, at 2023; Oettle & Howard, supra note 1, at 340.169. See supra note 122 and accompanying text.170. See Little, 649 F. Supp. at 1468-69.

D & 0 INSURANCE

vulnerable position.' 71 Considerations of unconscionability dictate,therefore, that an insurer should be required to cover legal expensesas incurred.

D. Analogy to Standard Liability Policies

Pepsico serves as a valid basis for requiring insurers to cover aninsured's defense costs as incurred. Given the reluctance of somecourts to utilize reasonable expectations, 7 2 contra proferentem17 3 andunconscionability 174 to establish a pro-insured holding,7 5 however,further, alternative support can be found by analogy to standardliability policies. 176

Standard liability policies differ from D & 0 insurance policiesin that they impose a duty upon the insurer to defend its insureds.177

D & 0 policies, by contrast, are indemnification policies. They imposeupon the insurer a duty to pay the costs of the defense of theinsured.'17 Accordingly, standard liability policies do not generatethe "as incurred" problem standard D & 0 policies do. 7 9 Moreinterestingly, however, the insured under a standard liability policyenjoys the benefits of an insurer-provided defense despite the pos-sibility of an ultimate determination that coverage under the policynever existed. 80

Despite the fact D & 0 policies have been traditionally regardedas indemnification policies,'8 ' jurisdictions today should construe

171. See supra note 63 and accompanying text. The insured's travails are com-pounded by the fact corporate defense lawyers do not work under contingencyarrangements, whereas counsel for stockholder plaintiffs usually do. See PracticalAspects, supra note 1, at 691.

172. See supra notes 113-35 and accompanying text.173. See supra notes 136-47 and accompanying text.174. See supra notes 148-71 and accompanying text.175. A pro-insured holding is one requiring insurers to disburse payments for

an insured's legal expenses as these are incurred. See supra notes 26-30 andaccompanying text.

176. For an overview of the different components of a standard liability policy,see generally LIABILITY INSURANCE, supra note 18.

177. See Goldstein & Gordon, supra note 1, at 2. This is commonly referredto as the duty to defend. See generally Oettle & Howard, supra note 1, at 342-43.

178. See Goldstein & Gordon, supra note 1, at 2.179. See id. This is because where there are no payments made to the insured

there is no timing issue concerning such payments. See also supra notes 20-25 andaccompanying text.

180. See Oettle & Howard, supra note 1, at 343. For an explanation of the no-coverage objection, see supra note 96 and accompanying text.

181. See Corporate Executives, supra note 12 (the D & 0 insuring clause suggeststhat the policy provides indemnity rather than liability coverage).

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484 FORDHAM URBAN LA W JOURNAL [Vol. XVI

them as liability policies, imposing a duty to defend upon D & 0insurers.

Logically, there is little substantive difference between a defenseprovided by the insurer (a liability policy construction) and onefinanced by payments disbursed by the insurer (an indemnificationpolicy construction). In both instances the net result is that theinsured is not forced to sustain the potentially enormous costs offinancing a defense.'8 2 Furthermore, in both instances it is the insurerthat provides the defense; only the method of provision differs.'83

In fact, the only real difference between an insured's defense undera liability policy and one under a D & 0 policy is that under theD & 0 policy the insurer can, in effect, deny any defense to theinsured, even where the plaintiff's complaint reveals that the insuredmay have coverage.8 4 This would be clearly impermissible if D &O policies were construed as liability policies.

Indeed, there is a judicial tendency toward reading such indemnitypolicies as standard liability policies.'85 According to one commen-tator, even Lloyd's D & 0 policy, 8 6 with its clear language toprovide indemnity coverage only, "would probably be construed asliability rather than indemnity insurance."'18 7 This is because of the"selfish" nature of indemnity contracts, as well as the insurer'sobligation to pay "losses" incurred by the insured:

In the first place, the definition of "loss" includes "judgments"as well as "payments."... It is well established that a covenantto pay "judgments'.' rendered against an insured signifies that thepolicy is intended to provide liability rather than indemnity cov-erage.

88

182. See supra notes 6, 121-27 and accompanying text.183. It is the different method of providing a defense in D & 0 policies that

generates the "as incurred" problem. See supra notes 177-79 and accompanyingtext.

184. By utilizing the no-coverage objection, see supra note 96, an insurer candisclaim payment on an "as incurred" basis. If there is then an adjudication thatprecludes an insured from coverage, the insurer can refuse to pay the costs of thedefense. The net result is that the insurer has denied the insured a defense.

185. See Knickerbocker Ins. Co. v. Faison, 22 N.Y.2d 554, 240 N.E.2d 34, 293N.Y.S.2d 538 (1968), cert. denied, 393 U.S. 1055 (1969); Corporate Executives,supra note 12, at 651-53. Such a reading, if valid, would impose the duty todefend, ordinarily found in standard liability policies, on D & 0 insurers. Seegenerally supra notes 17-18 and accompanying text.

186. See supra notes 13-14, 21 and accompanying text.187. Corporate Executives, supra note 12, at 652.188. Id. (emphasis added).

D & 0 INSURANCE

If D & 0 policies are read as liability policies, as they should be, 89

D & 0 insurers necessarily have a duty to defend. In insurance law,a duty to defend arises when the allegations in the plaintiff's com-plaint even arguably reveal that the insured might have coverage.' 9°

Under such a construction, then, the "as incurred" problem dis-appears, as a D & 0 insurer could not be permitted to await afinal adjudication without breaching its duty. The D & 0 insurerwould have to pay its insured's defense costs as incurred.

The similarity between an insurer-provided defense and one fi-nanced by the insurer, as well as the tendency toward reading D &O policies as standard liability policies, 9' leads to the conclusionthat D & 0 insurers have a "duty to defend' '

1 92 their insureds. Thepractical implication of this duty is that D & 0 insurers cannot bepermitted to deny their insureds a defense, which is precisely whatthey do when disclaiming a duty to pay an insured's legal costs onan "as incurred" basis. 193 The weight of the analogy dictates, there-fore, that D & 0 insurers have a duty to pay an insured's legalcosts on an "as incurred" basis.

V. Conclusion

Jurisdictions differ in the interpretation of D & 0 policy defensecost clauses. The Pepsico rule requires an insurance carrier to disburseinsurance money to cover an insured's legal expenses as they accrue,subject to reimbursement should adjudication show that there wereno grounds for coverage. Such a rule comports with the reasonableexpectations of the insured and is consistent with rules of contractinterpretation and principles of unconscionability. The rule also findssupport by analogizing D & 0 policies to standard liability policies.Courts should therefore adopt the Pepsico standard requiring D &0 insurers to disburse payments as legal costs are incurred bydirectors and officers.

Arthur P. Xanthos

189. See supra notes 181-88 and accompanying text; Corporate Executives, supranote 12.

190. See Westchester Resco Co., L.P. v. New England Reinsurance Corp., 818F.2d 2 (2d Cir. 1987); Gray v. Zurich Ins. Co., 65 Cal. 2d 263, 419 P.2d 168,54 Cal. Rptr. 104 (1966).

191. See supra note 185 and accompanying text.192. See id.193. See supra note 184 and accompanying text.

1988]